Client Biases and How They Affect Investor Behaviour

For people to make decisions on the fly, emotions come into play, and your past experiences affect your emotions and the decisions that you make going forward. Everyone will have different biases around their long-term wealth accumulation or how they want to spend money, and a lot of that's built on personal experiences through life and the community and the people that they deal with, are friends with, and go to school with. That all influences their biases as time goes on.

A bias comes in when emotion rules a decision. If you can understand the emotion and dig deeper into that, I think you can really see the biases that are going to affect future decisions as well. If you've been burnt by a pot cooking, you are going to use oven mitts next time. The same happens with investments; you are going to be very wary and very reluctant to dive into investments that might be appropriate for your portfolio and for your investment goals.

Overconfidence can be a problematic bias, and you tend to see it in situations where, for example, somebody might be happy to take a lot of risk because they're looking at the returns that they might get. Then, when not, if the risk event happens (i.e., markets naturally will come off 20-30% at certain times in the cycle), that's when you see that perhaps they were overconfident in their ability to take the risk. That's when you're having the conversations around, "Well, now is not the time to sell." Even if it wasn't the right strategy or the right investment mix, you're better off generally staying the course because the horse has bolted. Once you sell when markets are down, it turns from being a paper loss to a permanent loss.

Let's say you had a very good experience investing in property or individual shares, and because in that scenario you found that you generated good returns or had a positive outcome, there wasn’t a GFC-style event or a big downturn in the market where things got really shaky, you’re confident and happy to further concentrate your investments and your portfolio into this one particular style of investment management. The issue here is that when you have that confidence and haven’t had a bad experience, you can really be blind to the potential risk that you could be facing if something doesn’t go to plan.

Overconfidence is probably something you see a lot, and there are also biases where you tend to follow the herd in the direction they go when an investment becomes a big thing. Some of the key ones are anchoring bias, herd behaviour, and short-termism. The anchoring bias leads people to look at what’s happening in the very short term and assume that’s what will happen in the future, even though it actually has no relevance whatsoever. The herd bias means people buy what everyone else is buying and sell what everyone else is selling. The funny thing with the market is that if you go to a shop and things are on sale, you buy the stuff that’s cheap. But that’s not what people do in markets they buy as prices go up because they feel more confident, and they sell when things are on sale.

We talk to clients about their backstory, even going as far back as what life was like growing up and what money was like when they were younger. Often, that can uncover some biases that might not otherwise surface. Generally, you'll find a client will come in and tell you what they think they should do, and that usually directs you straight to their bias. I allow for biases when dealing with my clients by truly understanding their history. We have so many additional meetings before we even talk about portfolio investments, where I take the time to understand their history of managing money, how their parents managed money, their views on risk, and their feelings about managing investments rather than just relying on a standard set of questions.

Absolutely, biases come into play when portfolios are constructed. I think if we try to fit clients into a 70/30 profile or an 85/15 profile, that’s when we make mistakes. If we put everybody in the same category just because they answer a set of questions, that’s completely wrong. Psychology is such an important part of the plan because you can design the best financial plan, investment portfolio, cash flows, whatever it is for a client, that’s straight out of a textbook, and a university lecturer might give you 100%. But if it can’t be implemented in the real world because of people's biases, their psychology around money, or behavioural finance aspects, then if they don’t see the plan through, it’s useless.

Credit to Innova for inviting Steps Financial to be a guest on this video.